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Tuesday, 24 December 2013

This is the second part of my blog, dealing with the last BNR Newsroom of 2013, in which the downfall and nationalization of SNS Reaal was discussed
with a number of experts from politics, the banks and universities.

In the second part, the guests were:

Arnoud Boot, Professor Corporate Finance and Financial
Markets of the University of Amsterdam;

Paul: Michiel Scheltema,
do you see parallels between the downfall of DSB Bank and that of SNS Reaal?

Michiel: The lack of
coordination during the rescue of SNS Bank, was something that I was familiar
with in the days of DSB Bank. Also at DSB Bank, coordination was very hard to
find.

The cooperation
between De Nederlandsche Bank (Dutch National Bank) and the Finance Ministry
was already better during the nationalization of SNS Bank, than it had been in case of DSB.

By the way, DSB should
never have had their banking license, as there was too little counter weight in place against ‘the powers that be’ at the bank (i.e. Dirk Scheringa).

The commercial pillar of the bank was strong, but
the financial and prudential supervision was very weak. DNB can be blamed for
the fact that they did give the banking license to DSB after all. On top of
that, even after the banking license had been handed out to DSB, the
supervision by DNB remained poor.

The current
supervision has become much stronger, with Klaas Knot at the helm of DNB.
Expertise in banking affairs became much more important. DNB sends its people
to meetings of the Board of Directors of the big banks, as a matter of fact.

Paul: Are there really
improvements in the supervision at the moment, Arnoud Boot?

Arnoud Boot:Definitely! Something
has happened, of which many people thought it couldn’t happen. The crisis
showed us that many things can happen within the banking industry.

This
industry has the ability to shipwreck the whole economy. The problems, which started in the
US, could plummet the whole financial industry.

The banks came out of the dotcom crisis remarkably
well, in contrary to the stock exchanges, which lost a massive amount of money,
and the insurance companies. Consequently, the supervisors thought that the
banking industry had found a new and succesful business model, which protected them from harm.

The policy makers
thought that the banking industry was ruled by a new paradigm, since 2002. By
removing products from the balance sheets and selling the risks to the market,
through securitized debt obligations, people thought that the risk profile of
banks had become fundamentally lower.

However, as a consequence of the deployed
warrants, the risk came knocking at the backdoor of the banks.

In contrary to today,
people and supervisors thought that securitization would lower the risk for the
banks.

Ernst: What astonished
me, was that certain securities and collateral were on the balance sheets of
banks, against (nearly) 100% of coverage value. I am talking about collateral like mortgages and sovereign bonds of countries in the Eurozone. Was not something
really wrong with the risk awareness in those days?!

Arnoud: This was the
Euro-experiment at work, with dogmas like:

The Eurozone is stable;

We mutually
trust our governments and act friendly to each other;

We don’t steer too much
upon rules.

The result of this was, that not putting the sovereign bonds of the
euro-zone countries on 100% coverage value, would be seen as an act of mistrust.

The fact that
sovereign bonds from all Euro-zone countries were put on the balance sheet against 100% coverage value, came
from the dogma that the mutual creditworthiness within the Eurozone should not
be doubted at all. This was actually a political compromise and very naive in
hindsight.

Ernst: But were not ALL securities
and collateral overvalued in those days?!

Arnoud: That might be
true, but at least the other securities and collateral were subject to certain capital demands.

What was in fact counterproductive, however, was that Basel II alowed that the own rating models of the banks were used for the valuation of securities and collateral.

In other words: banks were allowed to decide
themselves, how much money they lended on the securities and
collateral that they received from their customers. These models were fundamentally wrong, however.

First: Some things
were missing in those models that were important in hindsight.

Second: There had been
a stable period of ten years. After such a long period, all risks will be
underestimated by the people involved. Every parameter in the large banks' valuation models underestimated those risks.

Third: The fundamental
conceptual flaw of these models was, that spreading risks does not matter anymore in times of crisis. All risks go
in the same direction actually: down the drain!

These models were based on the
concept that – as a consequence of diversification and spreading risks – the risks
would eliminate each other. This works fine, except… when it is really
necessary: in times of crisis!

Paul: How do you judge
the call for more measures and better supervision in politics these days.

Arnoud: The reason that
we are now in a crisis, is that politicians massively subsidized debt before
the crisis occured:

through the Mortgage Interest Deductability (MID) in The Netherlands;

through the National Mortgage Guarantee (NHG);

and through allowing Jumbo mortgages with a
125% loan-to-cover value ratio.

You were actually “robbing yourself”, when you didn’t
have a jumbo mortgage with 125% loan-to-cover ratio and NHG, as the government gave you such big tax breaks for it.

Politics did nothing
in the fifteen years before the crisis started. Of course, politicians are
right, when they state that DNB supervised insufficiently and that bankers can
be blamed for the crisis. However, they are guilty as well.

The ’mountain of
mortgages’ was actually created by the
government.

Wouter Koolmees: I agree
with the analysis upon the MID. Stimulating debt had been the bedrock of the
government for a long time.

The same mechanism was
in play, at the time of the so-called “Loan Shark policies”: “fiscal friendly” policies
from insurance companies, which carried such high expenses, that it was
virtually impossible to build up a decent lump sum amount with those.

The Dutch government
actually created the fiscal framework that enabled such loan shark policies.

The fiscal stimulation
of debt has been the starting point of the government. This also had
consequences for the balance sheets of the banks. And now everybody is
deleveraging: the banks, the government and the citizens.

This will take a long
time to do and it will hurt deeply.

Paul: Is it enough that
we make the supervision upon the banks more strict? Or is it only the starting point of a solution?

Wouter: The most
important thing is that banks have more capital and buffers, in order to be able to fight a
series of misfortunes. As a state official at the Dutch finance ministry, I had
to deal with ABN Amro and ING Bank.

Especially ING was a special
case. This bank almost defaulted as a consequence of a relatively small
portfolio of American Alt-A mortgages; (only)to the tune of €25 billion. This bank
had simply too little capital and buffers to be able to deal with a relatively
small financial blow.

Paul: Dolf van den Brink,
according to you the capital buffers were not the most important problem, right?!

Dolf van den Brink: That
is more or less correct. More than a 4% capital ratio is not necessary, in my
opinion. The main problem of the banks resided on the DEBIT side of the balance
sheet, where the loans and collateral are managed.

In the past, even banks and financial institutions with
a capital ratio of 35% defaulted, like for instance the Nederlandse Handels Maatschappij. Even with a very high
capital ratio, you can take so much risk – during the hunt for yields and
margin – that you might default anyway. That happened in the past.

Arnoud: The risk on the
debit side (i.e. the quality of the loans) should be mitigated, as a small
capital ratio is then not that important anymore. We are in favour of bringing the
current banks back to the core of banking: knowing your customer and knowing
his needs! Then there is no room for opportunism anymore.

The intrinsical opportunism
in transaction-based banking – with its strong attachments to the financial
markets and its lack of customer-knowledge – changed the risk profile of banks
so much, that it turned them into time bombs.

A sufficiently high
capital ratio alone is then not enough for mitigating the inconstancy of the
financial markets. You have to fight the inconstancy itself, in order to
prevent the downside risks on the debit side of the balance sheet from coming
in play.

Summarized: you should
not have too much risk at the debit side of the balance sheet and – on top of
that – you should have sufficient capital on the credit side of it, in order to mitigate risk.

Paul: Is that the core of
banking, Michiel Scheltema?

Michiel: I do very much
agree with this. And the relation with the customers of the bank should be the
core of the bank philosophy AND strategy.

Banks must realize how society is
thinking about their modus operandi. Banks do not realize sufficiently what
their customers want. In meetings of the Board of Directors, the subject should
be more often ‘the customer’.

Paul: Are you pleased
that De Nederlandsche Bank is visiting boardroom meetings these days?

Michiel: Definitely. The
younger generation is also much more aware of the necessity of a customer-centred
policy. However, many banks are acting too defensively yet.

Arnoud: We have been
talking about models. Models are meant as input for the decision process; they
are not the decision itself.

The decision itself must be based upon judgment.
That went wrong at SNS Reaal, with respect to the supervision of DNB. DNB should have asked
SNS: “What if the value of SNS Property Finance would be cut in half, how you
are going to deal with that?!”

The whole idea that the models worked fine
during the crisis, is a misconception.

An important question
is, how a bank can regain the trust from society. ING, for instance went much
more into a dialogue with society than the other banks. That dialogue is
crucial.

Michiel: If we don’t want to have a "choking" banking regulation and supervision, with 0% room for innovation and
improvisation, then the banks should develop new and innovative products.

And these products should be made
with the interests of the customers in mind. That innovation is very necessary
for the banking industry.

Wouter: A lot happened
during the last five years: from Europe as well as national politics. Still a
lot must be done, with respect to putting the customer in the centre and
increasing the capital ratios of the banks. Still, there has definitely been progress in the
process of protecting the customer.

The ban on commissions,
which were only rewarding the sellers of products, is such an example. However,
bankers and politicians are not the only guilty party in this crisis. That
would be much to simple.

Ernst: The banking
industry is in a split position currently. At one hand, politics is busy with
mitigating risks within the banking industry. At the other hand, the same
politicians are lobbying for handing out more loans to Small and Medium
Enterprises (SME). These two goals can’t be combined at the moment, as most SME
companies have a poor health currently, right?!

Wouter: That is indeed a
devil’s dilemma. And there is actually little demand for credit now, as the
economy is doing poorly. Still, we think that banking should become safer.
There are many good reasons to build up solid capital buffers, in order to
prevend 2008/2009 from happening again.

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About me

Hi, I am Ernst Labruyère. I live in The Netherlands with my wife Olga and my three children.
I blog on the Dutch, European and worldwide economies.
I try to bring you the interesting newsfacts and insights.
Besides doing photography and playing my electric guitar, I'd like to drive to my work with my racing bicycle. Saving the environment and getting rid of some pounds. I hope you enjoy this blog. Please let me know: @orbeaernie on twitter or ealabruyere@gmail.com